Danger! Horror! Get Out!

What we avoid and why we avoid it.

Veteran Motley Fool Hidden Gems members know what we love to find in a small company. Honest, competent management. Solid financials. High levels of insider ownership. Strong returns on equity and assets. Little or no Wall Street coverage. And a price that's right for long-term buyers.

What we don't often talk about, though, are the things that can go bump in the night. The traits of bad small businesses that make us fear and loathe them.

There are more than 7,000 public companies capitalized at less than $500 million. And, sure, there are loads of great winners in that bunch, poised to rise many times in value. Look back and you'll find businesses such as WD-40(NASDAQ:WDFC). Buying this well-known lubricant specialist 15 years ago and reinvesting the dividends would have given you a 10-bagger. That's a classic Peter Lynch investment.

But let's not kid ourselves. Out of those 7,000 companies, there are also tons of mediocre firms, and worse. Like Tolkien's terrible dragon, Smaug, they can incinerate your savings in no time. (Hey, we said this was scary stuff!) Quite seriously, if you're not doing business research and you don't know what to avoid out there, you could lose your fortune. When even solid companies such as Amazon.com(NASDAQ:AMZN) can drop precipitously from their all-time highs, you have to keep your eyes wide open.

Let's start with an example of what to avoid.

Case study: Charter CommunicationsIn our active online university community, a Hidden Gems member asked us more than a year ago what we thought of Charter Communications, a broadband cable company whose chairman and largest shareholder is Microsoft co-founder Paul Allen. The business is also substantially owned by Wally Weitz, a Nebraska-based investor whom Warren Buffett fans greatly admire.

Charter stock had fallen from $25 to $4.50, and our member wanted to know whether now was a good time to get in for a turnaround.

We'll start by saying that in Hidden Gems, we absolutely love the broken small cap that's poised for a turnaround. Show us a company whose stock has fallen 90% from its highs, whose chairman is a billionaire, and whose largest institutional owner is a close friend of Warren Buffett, and we'll sign up to do very careful research. That's exactly what we did with Charter Communications at $4.50.

But we did not like what we found. Here's why we warned against investing in this business:

Near the end of June 2003, I (Tom) wrote negatively about this stock when it was trading above $4. It's tough to go contrary to Paul Allen and Wally Weitz. But there was no turnaround in sight, and the company's balance sheet was cratering. Today, Charter trades at $1.23 per share, marking a more than 60% decline during a period in which the S&P 500 has risen some 20%.

Ouch.

What we do and don't fearOddly enough, our Hidden Gems team does not fear -- in and of itself -- high debt. Our recommendation Middleby(NASDAQ:MIDD) will carry more than $100 million in debt after buying a competitor and repurchasing founder shares. Yet the stock has risen 190% since the recommendation, and we remain very optimistic about its future. The company's operations are plenty strong to repay those obligations.

Nor do we fear companies that have fallen 90% from their all-time highs. Audible, which Rex found and wrote about, had fallen nearly to zero before turning around and showering its owners in newfound wealth.

Heck, even hints of SEC investigations can create attractive bargains on occasion. One of our favorite present recommendations is a company that just settled with regulators for mistakenly billing Medicare. We believe it could be a multibagger in the years to come. Companies as varied as American Express(NYSE:AXP) and Tyco(NYSE:TYC) have rebounded nicely from similar setbacks.

Each of these scary factors individually could make for a compelling investment as the stock price drops into the real value range.

So what was the problem with Charter Communications? The answer is the scale of its debt, running north of $18 billion, alongside harsh payment terms and emerging accounting problems. The numbers just didn't add up, and we're still very wary of the stock.

To find out which stocks we do love, simply take a free trial of Hidden Gems. Read about all the many small companies that have thus far produced outsized returns. If you don't like it, you can cancel within 30 days without paying a dime.

This article was originally published on Jan. 13, 2005. It has been updated.